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Are Bonds in a Bubble?

Investors are shoveling money into bonds faster than Lady Gaga can don another crazy outfit.

If you haven't already pinpointed the go-to investment of 2009 and 2010, you haven't been paying attention. Investors have been shoveling money into bonds and bond funds faster than Lady Gaga can don another crazy outfit. Billions of dollars have found their way into this sector recently, and everywhere you turn, market prognosticators are predicting a "bond bubble." Millions of Americans depend on the income from their bonds and bond funds to fund their golden years, so there could be lasting implications for scores of already battered investors if that bubble comes to pass. Will it?

Bubbling expectationsIt's hard to see how interest rates will move much lower from here. Short-term rates are practically at zero, so there's not a lot of room to go down. It may not happen soon, but rates will rise eventually, and that means bond prices will fall. No less a luminary than Bill Gross, in fact, has stated that bonds have seen their best days and investors should adjust to a reality of lower returns.

I am troubled by the massive amount of money moving into the fixed-income sector. It seems people are chasing returns and piling into this asset class at exactly the wrong time. That said, I would hesitate to describe the current situation as a bubble in the traditional sense. Investors who stuffed money into bonds out of fear of another market rout will likely be disappointed with their returns, but I don't think we'll see the kinds of losses typically associated with the popping of a stock market bubble.

Simply put, for investors who need to dampen volatility and protect their capital, in most cases there is no substitute for bonds. And while some intermediate-term bond funds are likely to experience lower returns when rates rise, research by Vanguard indicates that if investors hold on to those funds for five or six years, the increased interest payments from higher interest rates will actually offset the losses from selling bonds that have lost value as a result of the rate hike.

That means that by properly aligning your bond investments' maturity with your cash-flow needs, you don't need to try to time the market over the short run, and rising rates shouldn't have a devastating impact on your portfolio. Here's a rundown on how you might want to structure your bond holdings based on your time to retirement:

In retirementIf you have already bid farewell to your working years, odds are that fixed-income securities make up a majority of your portfolio holdings, so what the bond market does next will affect you more than other investors. That's why I recommend retirees hold enough money in cash or near equivalents to fund living expenses for the next five years.

Beyond that, don't feel that you need to shift money into short-term bond funds to wait for rates to rise. To preserve your purchasing power, make sure inflation-protected securities like Vanguard Inflation-Protect Securities (VIPSX) make up anywhere from 20% to 50% of your total fixed-income allocation (not counting your cash cushion). The remainder can be safely invested in an intermediate-term bond index fund and/or actively managed fund of roughly the same duration. If you buy individual bonds, a laddering strategy is a good idea.

Within 10 years of retirementIf you're in this category, you have some time before you need to tap your nest egg, so a temporary drop in the value of your bond holdings shouldn't call for any meaningful changes of plan. At this point, bonds may only make up about a third of your overall asset allocation, so you've got some room to breathe.

You may want to include some inflation-protected bonds, but you could devote most of your bond exposure to a well-diversified fund like Managers PIMCO Bond (MBDFX), which invests in Treasury, mortgage, and foreign bonds as well as corporate issues from stable, blue-chip firms.

Similarly, the low-cost, broad-market bond ETFs Vanguard Total Bond Market ETF(NYSE: BND) or iShares Barclays Aggregate Bond(NYSE: AGG) are another good option. Don't cut back on contributions to intermediate-term bond funds now out of a fear of rising rates. By the time you need access to your money, higher rates will likely mean you'll actually be earning higher returns than you would now.

More than 10 years to retirementIf you've still got a few decades to go before you point your RV toward the wild blue yonder, short- or intermediate-term interest rate movements won't greatly affect the long-term returns of your bond allocation. Even if you're pretty risk-tolerant, you should still aim for at least a 10% bond exposure to help cut down on portfolio volatility. You can add a touch more risk if you choose by investing some of your bond allocation in high-yield or global bond funds like Loomis Sayles Global Bond (LSGLX), which features foreign corporate and government bonds alongside U.S. issues. Since risks will be higher in these sectors, if you invest here, be sure to add a broad-market active bond fund or index fund that tracks the domestic market. Managers PIMCO Bond or Vanguard Intermediate-Term Bond ETF(NYSE: BIV) are solid choices.

Don't panic about where interest rates and the bond market are headed next. A bursting "bubble" and crippling bond losses are not likely. By sticking to your long-term plan and investing appropriately for your time horizon, you'll be set to ride out this next phase in the bond market cycle -- whatever it may bring.

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